55% of adults in America invested in the stock market in 2018.
For many decades Americans have uncovered new fortunes by investing in the stock exchange. Renowned investors such as Warren Buffet have demonstrated how buying stocks can drastically change one’s life.
But if you are the average American, big stock investors might seem like another world away from your reality. You might be asking yourself, “how does the stock market work?”
The truth is that while the stock market does create wealth for investors, it is not without some effort on their part.
Table of Contents
1. What Is a Stock?
A stock, also known as a share, is a unit of legal ownership in a company. Public companies list their stocks on the market for investors to buy, unlike private companies whose stocks aren’t publicly available.
There are different types of stocks, and most public companies list their common stock unless they have a dual class of shares.
When a company offers different classes of stocks, it means that you can own a piece of the company depending on the terms you prefer.
The stock market is a collection of exchanges like the Nasdaq or the New York Stock Exchange where companies can list their shares.
2. A Bear or Bull Market
Each market tracks the stocks of its listed companies, which result in the market fluctuating.
A bull market is when the stock prices keep rising across the various markets. The broader American stock market has been in the longest bull run since 2009.
A bear market, on the other hand, is when the stock prices keep falling across several markets.
There is no defined threshold to determine when it is a bull or bear market. However, stakeholders generally look at a price movement of at least 20% in the negative direction across several markets as a useful indicator.
3. A Correction vs. a Market Crash
If you want to invest in the stock market, you need to clearly understand what a crash and a correction are as they will influence your investment decisions.
A stock market correction is when the stock market drops by 10% or more. When there is a correction, it can be an indicator of a bear market.
A stock market crash, on the other hand, is when the stock market experiences a very sudden and drastic drop in stock prices.
An example of a stock crash was in 1987 when the stock prices went down by a jaw-dropping 23% in a single day.
4. Diversification Is Key
A critical tip on the stock market for beginners is that downturns are guaranteed to come. You can’t escape a bear market.
Therefore, it is essential to minimize your exposure by diversifying your portfolio. Individual stock picks are risky, and as a beginner, the best way to diversify your holdings is through an index fund.
An index fund holds a basket of different stock investments to protect you from the risk associated with one or two companies.
You can hold 10% of your investment in individual stocks you have researched and then spend the remainder on an index fund.
5. Don’t Buy on Stock Price Alone
You should never make the decision to buy a stock based on its price alone. There are other indicators you ought to factor in.
Public companies are required to report all their information every financial quarter. You can use this data to help you asses a stock’s viability.
When assessing stock recommendations, you should look at the stock’s earnings per share, price/earnings ratio, and price/book ratio.
While these three data points (readily available in the company’s quarterly reports) aren’t the only factors to consider, they will help you understand the company better.
6. Don’t Buy What You Don’t Understand
A cardinal rule and one of the stock market basics is that you shouldn’t invest your hard earned money in a business or industry you don’t understand. That is the surest way to lose your investment.
Invest in companies operating in a sector that you have an interest in as you will have the drive to keep up with what is happening in it.
Keep an eye out on the news and current affairs around the industry and economic landscape of the companies whose stocks you have bought.
It will help you spot trends that can impact your investment.
7. How Does the Stock Market Work? Making Money With Stocks
At the end of the day, you want to get into stock trading to make some money.
As a newcomer to this investment class, you need to know how stocks you hold can generate revenue for you.
A publicly traded company issuing stock pays out dividends. Dividends are simply the share of the profits a company pays according to the number of shares you have.
In light of this, you can purpose to invest in ‘safe’ blue-chip companies that pay a regular dividend for a passive income stream.
The other way stocks generate money is by their appreciation in value.
Over time stocks can become worth more than you spent on them, meaning that you can sell and make a profit.
8. Commit to Your Long-Term Holding
While you can get lucky buying and selling stocks fast (known as speculation) you will find more success when you hold stocks for the long term. An example is buying and holding stocks from a company known to be the largest defense contractor as they have a contract with the government up until 2035.
If you pick this strategy, avoid selling off due to some bad news or downturn. Although a bear market is inevitable, the good news is that in the long run a bull market always outlasts a bear one.
Set a date where you will review your long term stocks to avoid being cowered by volatility.
You Can Make Money in the Stock Market
Over the years, Americans have proven that you can grow new fortunes through investing in stocks.
Many average Americans who want to invest often ask the question, “how does the stock market work?” Before you sink your hard earned money to buy shares, take some time to understand the fundamentals of the trade.
Are you interested in growing your entrepreneurial skills? Keep reading for valuable business tips.